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PORTFOLIO STRATEGY - The Chilean Option
A few funds manage to generate big returns despite the country's high stock market valuations.
Although the chilean stock market has surged by more than 31 percent annually over the past five years, a number of global investors are approaching this dynamic market with hesitation. A recent Morningstar survey of Latin American funds domiciled in the U.S. found that the average exposure to Chile was nearly 2 percentage points below the MSCI Latin American benchmark of 7.63 percent. "Many institutions are perennially underweight Chile," says Credit Suisse Asset Management's Matthew Hickman, co-manager of the closed-end Chile Fund, which has generated five-year annualized returns of more than 41 percent through July 23.
Topping the list of concerns, says Hickman, is the view that the Santiago Stock Exchange's Indice General de Precios de Acciones' trailing 12-month price-to-earnings ratio of 23.8 is prohibitively expensive relative to the MSCI emerging markets Latin America index, which has a trailing P/E of 16.1. The high valuations have been fueled in large part by Chile's privatized pension system, which has been plowing funds into the local market. Investors worry that any reallocation of retirement pesos out of domestic stocks could deflate prices.
Some global managers avoid Chile simply because of the dearth of investment opportunities: Although the overall market is worth $215 billion, its limited free float of 39 percent reduces available capitalization to just $84 billion. The actual amount available to foreigners is even smaller given that pension funds sit on nearly $18 billion of shares.
Then there is concern about the economy's dependence on copper, the price of which has trebled during the current commodity boom. Chile is the world's largest producer of the metal, which represents more than 40 percent of its exports.
Despite these issues, a few emerging-markets fund managers have found signi®≠cant opportunities in Chile and have overweighted the country in their portfolios.
"Given Chile's highly stable political, economic and legal structure, solid corporate revenue and earnings growth and increasing consumerism, I believe the country merits its higher valuations," says Jeffrey Urbina, portfolio manager of the $1 billion William Blair Emerging Markets Growth Fund, whose 3.5 percent position in Chile is more than twice the weighting in the MSCI emerging markets index. "Chile is delivering emerging-markets expansion with lower risks that are typically associated with developed markets."
Urbina's sanguine view of Chile has paid off. Since its start in mid-2005, his fund has more than doubled in size. And for the 12 months through June 15, Urbina turned in a gain of 70.75 percent, topping the MSCI emerging markets index by 11.39 percentage points.
Urbina's biggest position is in Falabella, Chile's top retailer. The company's fashion, credit card and home improvement operations have delivered strong earnings growth in recent years. Earnings before interest, taxes, depreciation and amortization rose 34 percent in the quarter ended March 31. This performance has helped lift shares by 85 percent since Urbina bought a 1.1 percent stake in the company in October 2005. Falabella recently agreed to acquire food retailer D&S, a move most analysts say should quickly prove to be accretive to earnings.
Another fund manager who is twice overweight Chile is Patricia Ribeiro, manager of the $867 million American Century Emerging Markets fund. Its returns soared by nearly 34 percent annually over the five years through July 23 -- besting the MSCI emerging markets benchmark by nearly 3.5 percentage points a year.
In February the fund invested $1.9 million in the country's flagship carrier, LAN Airlines. "This has been a very successful restructuring story," explains Ribeiro. "More efficient operations and creative pricing schemes, supported by the country's booming economy, have transformed this troubled carrier into an increasingly profitable global airline." Ebitda margins, which were 8.73 percent in 2005, topped 14 percent in 2006 and are expected to approach 16 percent this year. In the first quarter of 2007, LAN reported record earnings of $86.1 million. The airline is executing a $310 million rights issue to ®≠nance further expansion. The American depositary receipts have climbed nearly 14 percent through mid-July, since Ribeiro bought the stock.
This fall new reforms are expected to go into effect, allowing the country's powerful pension funds, which currently own about one third of the market's free float, to increase their foreign holdings from 30 percent of assets to 45 percent. Analysts think that the market may shudder -- but not for long -- presenting a buying opportunity.
"We saw a 5 percent drop in stocks one day in February, when the market realized such change was in the works," says Raimundo Valdés, head of research at Santander Investment in Santiago. But he is joined by other observers who believe that future pension flows into foreign securities will most likely come from a portion of the $16 billion currently invested in bank deposits and from the $300 million of new monthly flows into pensions, rather than from sales of the funds' Chilean stocks.
Chilean stocks set a HOT pace
A comparison of annual returns for MSCI Barras Chile, emerging markets and world stock market indexes.
source: MSCI Barra.